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Riding Out the Gas Spike

With gasoline prices hovering around $2 a gallon, the blame game
has begun and political partisans are looking to settle scores. As
per usual, however, the political theatrics are drowning out the
real but complicated story behind the price spike.

Rising crude oil prices explain some of the price increase.
Since November, the price of West Texas crude has climbed $5.60 a
barrel; translated into gasoline prices, that’s about 13 cents per
gallon.

But gas prices have jumped by more than twice that - by 29 cents
per gallon.

The crude-price increase is not the result of production
cutbacks. Despite OPEC’s announced cuts, cartel production rose by
about 1 million barrels a day since last year. Non-OPEC production
is up another 1.5 million barrels a day.

But demand is increasing faster than production, particularly in
China. Red-hot economic growth in Asia is driving the world crude
market.

If we accept that about 13 cents of the price increase for a
gallon of gas since November is because of surging demand for
crude, that leaves 16 cents unaccounted for. Some of the price
spike can be attributed to the temporary rise we see about this
time every year, when refineries switch from making winter-time gas
blends to more expensive but environmentally friendly summer
blends.

Tight oil-refining capacity is also playing a role - not because
environmentalists have shut the door on capacity expansions, but
because demand for gasoline in the Far East is claiming almost all
the previous unused capacity.

A tight market, however, means suppliers can charge more for
gasoline. Profit margins in the refining sector are up, which means
investment in new refining capacity will follow.

New environmental regulations, however, threaten to dampen the
incentives to invest in new refining capacity for the American
market. Of particular concern is a new federal rule that began to
take effect this year requiring refineries to strip most of the
sulfur out of gasoline (search). Retooling refineries to meet the
new standard is a major one-time expense. Refineries in Europe and
Japan have already done it to comply with similar regulatory
standards. Many U.S. refineries will lay out the needed capital,
but others are expected to simply close - and some already
have.

Another Green hammer threatening the refining sector is the
prohibition of MTBE (an oxygenate made from petroleum) that takes
effect this year for gasoline sold in the California, New York and
Connecticut markets.

The background: Federal law requires areas that are in violation
of national clean air standards to use oxygenated fuel. Now that
MTBE (search) is out of the picture, the only oxygenate left to
those areas is ethanol (search). But ethanol costs more than
MTBE-mixed fuel to make and transport; those costs will surely show
up to some degree in gasoline prices this summer. Moreover,
carving-up special gasoline regulations for different parts of the
country increases the chance that unforeseen supply disruptions
will send prices in those “island markets” soaring.

There’s little we can do about world crude prices - and little
we should do about the new sulfur rules. But the federal
oxygenated-fuel requirement is another matter.

Before computer-controlled fuel-injection cars came along, the
oxygenate rule did indeed reduce pollution. But 20 years later, the
rule serves no environmental purpose. Instead, it is simply a
welfare program for the Midwestern corn-based ethanol industry.

New York Gov. George Pataki has asked the EPA for a waiver of
the oxygenate rule, but the EPA has not acted on his request. Not
only should the EPA provide the waiver, Congress should scrap the
oxygenate rule altogether.

That having been said, there’s little else we can do but ride
this price spike out. High prices will induce new supply faster
than will governmental bureaucrats or politicians. There’s no
conspiracy afoot - just the periodic gyrations of Mr. Supply and
Ms. Demand on the economic dance floor. Getting in their way will
only prolong and worsen the spike.